How one founder could pay no taxes on a $196M gain with a ROTH IRA

When it comes to the topic of wealth preservation, there is no shortage of strategies. One method startup founders could take involves putting a percentage of their startup stock into a ROTH IRA retirement account to create a tax-advantaged nest egg.

What is the ROTH IRA?

The ROTH IRA allows you to put up to $6,000 in 2021 ($7,000 if you’re 50 or older) into an account which grows tax-free and can be removed without restriction or taxes due starting at age 59 ½.

There is no cap to the amount of money one can accumulate in a ROTH IRA, making it a popular vehicle for any investment that you want to grow without penalty and without any tax consequences when you withdraw.

Founder’s stock and potential pitfalls

The ROTH IRA is permitted to invest in private businesses not controlled more than 50% by the plan holder, so what about using the ROTH IRA to invest in your startup’s stock?

As long as you control less than 50% off the company, the IRS has no restrictions on investing in a business you partially own.

Real world ROTH IRA success stories reported that in 2010 the chairman of Yelp sold 3.1 million shares of Yelp stock held in his ROTH individual retirement account, receiving around $10.1 million in profit, tax-free. Assuming he did not withdraw early, there are no taxes on that gain.

In 2014, the Government Accountability Office (GAO) released a report discussing the impact on the federal government from the revenue loss that occurs with this “circumvention of the longstanding rationale for IRA contribution limits.”

The report included an example in which one company’s shares were valued at $0.00125 each in 2008 and 4 million shares were placed in a Roth IRA. The company eventually got a venture capital investment, went public, and saw its share price go to $60. The founder could end up with $196 million in the IRA, according to the GAO. (The company and founder were kept anonymous.)

What to consider before investing

If you’re considering pursuing this strategy with your own startup, here are some guidelines you need to follow regarding restricted transactions with ROTH IRA’s before investing in your company’s stock.

  • Make the investment as early on in the company life as possible, so no arguments can be made that the stock has experienced an appreciation in value.
  • Control less than 50% of the company at the time of investment.
  • Get a valuation done immediately before the investment to ensure the FMV of stock is what your ROTH IRA pays for it.
    • There should be no mismatch with the value vs. purchase price. This will keep the IRS from looking at the investment as “abusive.”
  • Be sure to hold your founder’s stock in multiple investment vehicles, so it is not concentrated in one account.

If this tax-saving method worked for the founders of Yelp and other successful startups, there’s a good chance it could work well for you.

What does a President Biden mean for the R&D Credit for startups? Here’s our prediction.

Will a President Biden change the R&D Credit for startups?

The answer is maybe.

Biden and his campaign have not made any specific statements on the R&D Credit. Though, he has committed to greatly increasing federal spending–most likely through the Small Business Innovation Research (SBIR) program and tax credits–on R&D, especially when it comes to AI, quantum computing, clean energy, and 5G.

Both parties acknowledge that federal R&D spending needs to increase.  Current federal R&D spending is now half, as a percentage of GDP, compared to the 1980s. Part of this R&D spending will probably be through increased tax credits, including enhancing the PATH Act R&D Credit. 

Keep in mind, the Obama-Biden Administration (through the PATH Act) introduced this refundable, very startup-friendly credit.

Our prediction

Currently, the PATH Act R&D Credit maxes out at $250K per year for the first five years. In the past, certain members of Congress have floated the idea of raising the annual limit to $500K and received bipartisan support, but somehow that got buried in the committee process. 

We feel that the Biden Administration will likely rekindle this $500K limit and also expand it so that startups with more than $5M in annual sales will be eligible (currently, you are not eligible if your annual sales exceed $5M per year).

An Interesting statistic

For Tax Year 2017, $53M in PATH Act R&D credits were claimed, per the Treasury Department. (This is the latest stat on the R&D Credit).  For Tax Year 2019, Accountalent helped clients claim over $11.8M in PATH Act R&D Credits.

Not only can Accountalent help you find out if your company is eligible for the R&D Credit–and claim that $$$–but we can also recommend a firm that can put together an IRS-compliant R&D Credit study in an inefficient, inexpensive manner that will take very little of your time or involvement.

Want to find out if Accountalent is right for your startup? Click here to schedule a free consultation call.

California startups beware: Moving your business out of The Golden State might not be such a golden idea…

A lot has happened since the start of 2020. More companies and employees than ever are working remotely. Since the onset of COVID, several of the California startups we work with have moved their headquarters and employees from CA to another state (TX seems to be very popular).  The client is often very happy because they will not be required to pay the annual CA minimum $800 income tax anymore. 

For startups, though, beware before withdrawing officially from CA and filing a Final Income Tax return. The long-term implications could far exceed the short-term benefit.

Most startups will accumulate Federal and State net operating losses (NOLs) during their initial few years before they become profitable.  These losses can be carried forward to eventually offset taxable income.

In other words: These losses are very valuable.  

For California (and most states, in general), if a Final Income Tax return is filed, any CA NOLs are lost forever.  This is not a problem unless the startup decides to move back to CA or has future nexus (an employee, property, etc.) in CA.  In that case, there is no shelter from CA income taxes if, or when, the startup becomes profitable.

Example: California Startups NOL Mistake

  • Startup operates for initial 2 years in CA and has accumulated taxable losses of $2M at the end of Year 2.
  • At the end of Year 2, startup files a Final CA tax return and moves to another state.
  • In Year 4, startup has $1.5M in profits and moves back to CA. 
  • CA taxes for Year 4 are $135,000.
  • If the startup had kept filing in CA for Years 2 and 3, the NOLs would have offset taxable income in Year 4, with an additional $500K of NOL available for Year 5.  
  • So, to save $1,600 ($800 CA minimum tax in Years 2 and 3), it ended up costing the startup $133,400.

Be careful before withdrawing from any state where there is a Net Operating Loss Carryforward. Accountalent has helped over 3,000 startups with their taxes. Contact us today and avoid any costly mistakes.

7 Ways Your Taxes Will Change Under a President Biden

Calling all startups and startup founders: now that the election is almost finalized, the time to start tax planning is now. Although many specifics are not yet fully developed, here is what we know right now about how a President Biden plans to change your taxes:

1. Corporate Tax Rate

Joe Biden plans to increase the corporate tax rate from 21% to 28%.

2. Foreign Subsidiary Tax Rate

Per Biden’s campaign website, he will double “the rate of the Trump offshoring tax rate and it will apply to all income.” This would increase the Global Intangible Low-Tax Income (GILTI) tax rate on foreign subsidiary income from 10.5% to 21%.

3. Manufacturing Tax Credit

Biden will seek to implement a 10% “Made in America” tax credit for certain costs of businesses that invest in “revitalizing closed or nearly closed facilities, retooling or expanding facilities, and bringing production or service jobs back to the U.S. and creating U.S. jobs.”

4. “Claw Back”

A startup that moves jobs overseas that could have been offered to Americans will be denied certain tax benefits and will need to return any public investments previously received.

5. Qualified Business Income Deduction (QBID)

IRC Section 199A currently provides a 20% deduction that reduces LLCs’, contractors’ and consultants’ taxable income. Biden plans to eliminate this deduction. However, you may still qualify if your taxable income is less than $400,000.

6. Capital Gains Tax

When you sell your startup and your gain exceeds $1M+, your long-term capital gains tax rate will increase from 20% to 39.6%.

7. Estate Tax

When you die, your estate tax rate will increase from 40% for estates over $11.6M to 45% for estates over $3.5M.  Therefore, an estate of $10M will now pay estate taxes of about $3M instead of $0. This change will make estate planning more important than ever.

As of right now, Biden has not indicated whether he will change the R&D Credit. However, with the amount of changes on the table, there is no telling what could happen next year.

In tax year 2019 alone, Accountalent helped 250+ clients claim over $10 million in PATH Act R&D Credits. Don’t leave cash on the table. Contact us now for a free consultation before these changes take place.

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